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Inflation in Vietnam fell for a sixth consecutive month in February to an 11-month low, figures released on Friday showed.

That’s stoked speculation that the country’s central bank will reduce interest rates: according to Bloomberg, the yield on benchmark five-year bonds fell 34bp during the day, the biggest one-day drop since March 2010. Capital Economics also expects an easing of monetary policy to support growth. But too big a rate cut, it warns,  could damage Vietnam’s fragile economy.

Growth could certainly do with a kick. Last year, Vietnam’s economy grew by 5.8 per cent – compared to an average rate of 7.7 per cent from 2003 to 2008 – and the signs so far are that 2012 has also been weak.

Gareth Leather, analyst at Capital Economics, wrote:

The banking sector would also benefit from lower interest rates by making it easier for borrowers to service their debts. There is growing concern among government officials that the surge in bank lending over the past few years will lead to a steep rise in non-performing loans (NPLs). According to official estimates, the NPL ratio increased from 2.1 per cent at end-2010 to 3.8 per cent at the end of last year, although the real figure is likely to be much higher.

Consumer price inflation fell to its lowest level in nearly a year in February – albeit a still daunting 16.4 per cent a year – having peaked at 23 per cent in August. And Leather reckons that because of expected falls in food inflation, it’ll stay relatively low, trending down over the rest of 2012 and ending the year in the high single digits. Vietnam’s benchmark refinancing rate currently stands at 15 per cent – so if Leather’s forecasts are correct, there is scope for cuts.

Why, then, must Vietnam’s central bank be cautious? The problem is that despite that clear downward trend, inflation in Vietnam is still much higher than in its regional peers.

Source: Thompson Datasteam (via Capital Economics note)

So cutting rates too quickly would undermine the central bank’s credibility on its commitment to reducing inflation – which already took a serious hit when monetary policy was dramatically loosened during the 2008-09 global financical crisis. The refinancing rate halved from 15 per cent in October 2008 to around 7 per cent in May 2009.

Also worrying is that cutting rates could put further downward pressure on the dong, says Leather. If the government is forced to devalue the currency, Vietnam risks being caught in a vicious circle – in which the rising cost of imports would compound inflationary pressures.

Apart from by easing monetary policy, how else could Vietnam support growth? A report by McKinsey Global Institute released on Thursday argues that the country must boost its labour productivity.

From the report:

The MGI estimates that, taken together, an expanding labour pool and the structural shift away from agriculture contributed two thirds of Vietnam’s GDP growth from 2005 to 2010. The other third came from improving productivity within sectors. But the first two drivers are now waning in their power to drive further growth.

McKinsey concludes that Vietnam will need to boost its overall labour productivity growth by more than 50 per cent – from an annual 4.1 per cent to 6. 4 per cent – if the economy is to meet the government’s target of 7 to 8 per cent annual growth by 2020. Without that boost, it will only grow at between 4.5 and per cent a year.

Regardless, it seems an interest rate cut is on the agenda. Only last month, Nguyen Van Binh, the country’s central bank governor, said the SBV would look to adjust rates to “more suitable levels”. February’s promising inflation data will only strengthen that conviction.

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